A Complete Guide to Inventory Financing and its Benefits

An organization’s inventory — which includes its raw materials, work-in-progress goods, and finished goods — forms the backbone of its supply chain.

Any problem in even one of these components creates unnecessary delays and increased costs. For example, if there is not enough material in stock, that affects the production volume of an organization.

Likewise, if a company’s inventory conversion period is extended, it will take exponentially longer to break even or become profitable in the market.

Inventory financing is key to resisting such problems, especially for Small and Medium-Sized Businesses (SMBs).

What is Inventory Financing?

This is a short-term financing option for SMBs, who use the money to purchase stock and materials that they will employ to produce and sell products later.

As a result, this type of import financing can help organizations replenish and consolidate their inventory levels.

Normally, inventory financing consists of short-term loans and revolving credit lines that enable businesses to make emergency withdrawals and fund usage.

In this way, inventory financing is an ideal fund-creating avenue for stabilizing cash flows, especially during periods wherein sales are volatile (for example, a seasonal sales downturn).

Incase businesses need more funds to purchase inventory, they can utilise credit facilities, so they don't use up all their funds.

Inventory financing is an asset-backed option in which the products and materials purchased with the funds are the borrowing collateral.

The loan's value provided by the lender is based on some or all of a business's inventory or stock valuation.

An example of of how inventory financing works is as follows:

A vehicle dealership named Cadmium Motors needs to expand its inventory to keep up with a seasonal rise in new vehicle orders and new car sales. To meet the rising demand, the dealership needs to purchase new cars from a vehicle manufacturer named Kree Vehicles. This will cost Cadmium Motors more money than they have set aside for the purpose.

Therefore, Cadmium Motors approaches a financing company to bolster its inventory funds.

The financing company sends auditors to closely evaluate the value of the cars being purchased. After the check, the financing company approves the loan if its creditworthiness and inventory value criteria are met. When vehicles are sold, Cadmium Motors can use the money earned in the transaction to repay a part of the loan and purchase more inventory to sell.

The financing company has offered inventory financing as a revolving credit line. So, if Cadmium Motors is selling well and is in need of more money to keep selling, they can withdraw money and repay it later to the financing company

Which Financiers Provide Inventory Financing Solutions?

Certain financial bodies may specialize in providing inventory funding solutions to businesses, especially SMBs. Some of these financiers are:

• Online Financiers Online financiers, also known as online lenders, offer inventory financing options that are more flexible than standard small business loans. Such lenders are also more likely to work with businesses having moderate to poor credit ratings, making them a much more viable alternative compared to other, more traditional financiers for businesses.

Compared to banks and other financial institutions, online lenders also tend to simplify the application and fund release procedure.

Drip Capital is one such online inventory financing company based out of Palo Alto, California. With novel trade finance products for inventory management, we've helped more than 50+ importers in the United States to improve their working capital position and profitability with on-demand financing.

• Banks, Credit Unions, and Other Traditional Lenders Banks and credit unions provide steady affordability and convenient-to-procure small-business loans.

However, such bodies are generally less likely to offer inventory financing due to its characteristic risks for lenders.

Therefore, many financial institutions offer small business loans, which can be considered a kind of inventory financing.

Small business loans generally tend to involve collateral, longer terms, and lower interest rates. The latter two aspects of these loans may skew businesses to opt for this alternative.

On the other hand, the lenders of small business loans require businesses to have a strong credit score, several years of industry establishment, and steadily growing annual revenue and profitability. So, not all inventory finance seekers will be able to secure funds through this avenue.

What Are the Features of Inventory Financing?

A typical inventory financing arrangement has the following characteristics:-

• It is a collateral-based financing option Inventory finance is a secured financing option, which means that businesses will need to enlist certain assets they possess as collateral in case they cannot repay the money borrowed from their financier. In most cases, the products and resources that borrowers purchase using the funds being borrowed from the financier act as collateral. In the example mentioned above, the cars being purchased by Cadmium Motors using the loan, are itself the collateral in the financing arrangement.

• Payment percentage, interest rates offered varies from lender to lender In inventory financing, businesses receive funds on the basis of their existing inventory valuation. While that is a standard metric for evaluating the amount of money provided, financiers may also add their own terms and conditions to the mix. As a result, the rates of repayment, credit period, turnaround time may fluctuate marginally from one financier to another.

• It resembles a revolving line of credit Inventory management needs businesses to have positive cash flows at all times. So, during times of financial downturn and lower sales, businesses still need an injection of cash to fall back on to keep their cash flows in the green. Through inventory financing, businesses can get this much-needed financial influx during such periods. In this sense, inventory financing resembles a revolving credit line.

• The released amount depends on the inventory valuation set by the lender An inventory financing company will use its own auditors (or auditors from a financial institution of its preference) to conduct an inventory status evaluation of a loan-seeking business. Based on this evaluation, the financier company will set the amount to be released, the repayment rate, the repayment period, and other aspects of an inventory financing before providing funds to a seeking company.

The features above do not necessarily span all the inventory financing types and

How Does Inventory Financing Help Businesses?

Inventory financing is highly beneficial for businesses that have a dominant percentage of their capital tied up to their business inventory. Therefore, manufacturers and dealers of goods use this financing option most frequently.

Inventory financing helps businesses in a multitude of ways, some of which include:-

• Stabilizing Cash Flows SMBs generally face several losses and cash flow gaps before they can break even or start becoming profitable and, eventually, rise above their SMB status. Inventory financing offers relatively quick liquidity to such businesses to stem such gaps and maintain steady cash flows during all periods.

• Receiving Funds Regardless of Company Size and Experience An inventory financing loan does not require an organization to be established. Several financiers require fund seekers to be established for a period of at least six months to be eligible for an inventory financing loan.

• Maintaining Ownership of the Company Inventory financing loans enable SMBs to refrain from having to sell their capital assets or mortgage them to secure money for inventory consolidation. In this way, SMBs can retain a majority ownership of their assets by availing this financing option.

• Building Resilience to Seasonal Volatility Unsteady revenue and profitability due to seasonal causes are common for any businesses.

However, while large organizations have the contingency resources to weather seasonal volatility, SMBs may not have the luxury to do the same. By providing funds, Inventory financing loans provide such businesses with a much-needed liquidity cushion to possess a degree of imperviousness during peak or tough seasons.

• Adding Business Flexibility Generally, financiers position inventory financing loans as short-term loans with quick repayment. As opposed to long-term loans that end up with SMBs repaying loan installments for months and years on end, businesses can pay off such loans within shorter timeframes by selling out their inventory to end consumers.

What Are the Disadvantages of Inventory Financing?

SMBs need to weigh all their options before deciding to go for inventory financing, as this option contains its fair share of negatives, some of which include:

• Difficult to Secure Inventory financing loans, especially the ones that banks and traditional financial institutions provide, can be notoriously difficult to get for businesses due to their high credit score requirements. The sheer amount of documentation involved in the process, combined with the credit score and collateral requirements, may put several SMBs off this financing option.

• High-Interest Rates In many cases, inventory financing loans have high repayment interest rates, making the repayment amount several times greater than the one borrowed from a financier. The high-interest rates act as a deterrent for SMBs with low budgets.

• Short-Term Funding Option An inventory financing loan is more of a quick fix rather than a long-term solution for businesses. Such loans help businesses with sorting financial issues with their inventory instead of enabling businesses to budget for future projects or growth plans.

What Are the Types of Inventory Financing?

Inventory financing options are not limited to just standard term loans, but can be offered in many different forms. We've the various types of inventory financing separately in this post. Some of the most common ones are:-

Line of Credit

More often than not, these credit lines are revolving in nature. Credit lines enable SMBs to purchase materials and other inventory on credit. After repaying it, businesses can dip into the replenished credit available again for withdrawal. Additionally, SMBs, more often than not, do not have to pay interest on the part of the credit they do not use.

Inventory Loan

These are short-term loans with quick turnover time to quench an SMB's inventory financing requirements within a quick time-frame, for a lower financing amount and short repayment periods (normally, in the six to seven-month range). Using inventory loans improves the inventory conversion of such businesses.

Vendor Financing

After agreement on certain payment terms, vendors let buyers purchase inventory from them and lend them the money to buy from them. This money is payable to the vendors at a later date, usually after 30 to 90 days. This is a simple and yet one of the most effective financing options. Also synonymously referred to as a vendor note or vendor loan. We've covered this topic separately here.

Financing for Inventory Purchase

These are cases where funds are extended precisely for purchasing inventory and the inventory itself is also the collateral in the transaction. It is also the most popular definition of the term.

Inventory backed financing

In several cases, financiers may also extend the loans based on the current inventory that a reseller already has stocked. The loan itself may be used for multiple purposes including funding operations and need not be restricted to purchasing inventory. Business owners can purchase inventory through a different funding method known as purchase order financing.

How Does Inventory Financing Work?

As specified earlier, inventory financing can play out in the form of term loans or credit lines. In term loans, the financier provides the full amount upfront. A business can repay this amount over fixed monthly payments over an agreed period. On the other hand, while using a credit line, businesses only have to repay the interest amount for the credit used. Once the interest payments are done, the withdrawable credit limit reverts to the original sanction.

The working mechanism of inventory financing can be explained with an example: if business A Ltd. wishes to purchase $ 500,000 worth of inventory to ready itself for its next production cycle, it will contact a financier.

The financier will then conduct a thorough evaluation of the inventory to ascertain its current market value. The lender's auditing team finds that the valuation is $ 350,000. The lender provides 80% of that value, which is $ 280,000. The monthly interest rate for the same is 17%.

If, over the course of its production cycle, A Ltd uses the full amount provided, it will need to pay back (over 12 monthly installments over a year) an net amount of $ 327,600 (borrowed amount + accrued interest). Every month, that translates into USD27,300 repayments made by A Ltd to the financier.

In case the financing is done through the credit line route, the business can repay the amount it withdraws out of the USD280,000 credit limit (with interest). Once the repayment is made, the credit limit replenishes into USD280,000 again.

In both instances, the inventory purchased using the borrowings is seized as collateral if A Ltd is unable to repay the used amount and interest.

Documents such as a filled application form, passport-sized photographs, bank statements, the bank statement, balance sheet, and profit and loss statement of the past one year (both must be audited) along with income tax returns statement, sales tax returns statement, A Ltd's registration certificate, documents specifying information about the collateral, and income and address-proof documents for A Ltd.

What Factors Are Considered By a Financier During Inventory Financing?

In the records of a loan-seeking company, a financier generally evaluates certain factors, including:-

• Past Credit Repayment Violation Financing companies closely monitor records of past borrowings of loan-seekers. So, if they detect instances wherein the company has defaulted on payments, their inclination to release loan funds for them automatically reduces. No financing company would want to expose themselves to unwanted credit risks at the hands of past payment defaulters.

• Profitability The overall financial state of a company plays a key role in the decision-making of financiers while they determine whether a loan-seeker must get funds or not. Businesses with higher stability and profitability are a safer bet for financiers than those with volatile finances.

• Credit Score This is the ultimate factor of a company’s loan repayment ability. A business's credit score strongly represents the liquidity it possesses for repaying borrowed money. Generally, businesses with higher creditworthiness are likelier to receive inventory funding than those with middling or low scores.

• Inventory age The value of inventory continuously depreciates with time. As stated earlier, financiers provide funds based on the existing inventory valuation of the loan seeker. Therefore, businesses looking to raise finances for inventory replenishment must do so when the value of their inventory is peaking.

• Establishment Year of Company Although this may not be every financier’s requirement, the number of years a company has existed paints an accurate picture of its stability and longevity. The older any company, the higher its financial stability and likelihood of repaying borrowed loans will be.

What kind of Businesses Need Inventory Financing?

As stated earlier, businesses with a high percentage of their capital tied in their inventory are more likely to seek inventory financing than most other businesses. So, businesses in the manufacturing, construction, retail, and similar industries may seek inventory financing more than the ones in other sectors.

What Are the Steps to Apply for Inventory Financing?

The application process to secure an inventory financing solution firstly necessitates the following — the submission of documents that indicate the following: that the company is operational and located in its place of establishment for several years, has a high-value in terms of inventory possession, has been operational for at least six months, has a strong credit score, and other aspects.

1. Firstly, an SMB approaches a financier physically or online.
2. Nextly, the representatives from the company fill an application form and provide its verification documents to have its legitimacy and inventory details validated.
3. Thirdly, the financier will evaluate the inventory value by having its auditors visit the offices and production facility of the company.
4. Nextly, the business accepts financier's terms and conditions and pledges its inventory as collateral.
5. In the last step, the financier sanctions the loan.

What Are the Inventory Financing Rates and Terms?

As one can expect, globally, the inventory financing rates, interest rates, and terms/conditions will fluctuate wildly. Financing can occur from 70% and above of the inventory value of businesses (based on the financier's evaluation), provided that inventory prices are relatively non-volatile. The interest rates can vary from as low as 5-6% to about 15-20%, or sometimes even more, for inventory financing.

What Are the Alternatives to Inventory Financing Loans?

There are three options that can be just as alluring as inventory financing loans for businesses:-

• Invoice Factoring

A practical factoring method in which businesses leverage their trade receivables with a financier to receive funds.

This financing avenue is useful to offset credit risks for sellers of goods. It can be an effective alternative financing option to optimize inventory management.

• Business Credit Cards

This is also a revolving credit line that promises quick repayment times and instant credit replenishment for businesses. However, this instrument of financing comes with high rates and fees.

• Gold Loans

Businesses can secure funds against their gold assets. These loans have, generally, low interest rates and relaxed repayment schedules.

The credit history evaluation, documentation, and audit-based investigation are much more lax compared to the processes involved in securing regular inventory financing.

What are the differences between Inventory Financing, Accounts Receivable Factoring, and Standard Working Capital Loans?

Inventory financing may share a few similarities with factoring — short-term, working capital repairing, limited scope, to name a few — and working capital loans, but there are several differences between the three as well, including:-

Inventory financing is a highly beneficial option for SMBs all across the world to raise money to manage their inventory efficiently. Its importance can only be felt in the case of a deficiency of money to stabilize a company’s inventory reserves.

FAQs on Inventory Financing

• How long does it take to process an application for inventory finance? The time required for processing an application varies wildly. It could range from as low as 24 hours to a few weeks for some financiers across the globe.

• What kind of products are eligible for inventory finance? Inventory financing can be used to purchase stock, raw materials, and other assets that count as the inventory of an organization.

• Is Inventory Financing the best option for any business? Although it is a useful option, businesses can also check other alternatives such as gold loans and invoice factoring, just for the sake of comparison to find out what suits them best.

• Is collateral required for inventory financing? Yes, the collateral is the inventory purchases made using the borrowed amount from a financier.

• Can I apply for Inventory Financing with no credit history or no existing inventory? Although the lack of credit history is not problematic when applying for inventory financing, businesses with no existing inventory are more likely to find it challenging to obtain funds.